The Short Book on Investing

The Short Book on Investing

1. Market Randomness and Active Management: Markets are moved by news. News is unpredictable and random by definition. Therefore, the markets movements are unpredictable and random. However, this market randomness does have a positive average of about 10%/year because capitalism works. Active managers who have claimed to outperform a market average or index have also implied that they have the power to predict tomorrow’s news. But since it is impossible to consistently predict the future, the results of active managers are unpredictable and random. This concept is known as the Random Walk Theory and it was first discussed in The Theory of Speculation, a paper written in 1900 by Louis Bachelier. In 1964, MIT Professor Paul Cootner published a 500 page collection of research papers on the randomness of the market titled, The Random Character of Stock Market Prices. In 1965, Nobel Laureate in Economics and MIT Professor Paul Samuelson wrote his now famous paper, Proof That Properly Anticipated Prices Move Randomly. Also in 1965, University of Chicago Professor, Eugene Fama wrote his highly regarded paper, Random Walks in Stock Market Prices. After carefully reading this extensive collection of peer reviewed research, you will be convinced of the randomness of stock market prices.

2. Skill or Luck: The average actively managed investment must underperform the indexed investment, when all costs are deducted. Those actively managed investments that beat the indexed investments fail to consistently beat the index in the future. The reason for market beating performance in a random market is simply due to luck and not due to a skill that is repeatable. Research shows that only about 3% of active managers beat an appropriate index over a 10 year or longer period. Needless to say, it is nearly impossible to predict those winners in advance. Lucky investors are well advised not to expect a continuation of their good fortune.

3. Index Portfolios Best Capture Risk and Return: Actively managing your money will create higher risk and lower returns than a globally diversified, tax-managed, and small value tilted portfolio of index funds. Due to commissions, management fees, margin costs, taxes, stock randomness, and market efficiencies, you will slowly transfer your money into the pockets of stock brokers, mutual fund managers, hedge fund managers, and the many other individuals profiting from your numerous transactions and your lack of understanding of free market principles. Active management is hazardous to your wealth. A recent study by Brad Barber of the University of California, Davis, showed that 82% of the 925,000 active traders studied lost $8.2 Billion/year from 1995 to 1999.

4. Returns from the Risk of Capitalism Rank Highest: Capitalism is a great idea that has worked for centuries. It has provided an annualized return of about 10%/year since 1926 and has the highest rate of return of all investments tracked over periods of 50 years or more. That rate of return is explained by the difference between the low risk of capital and the high risk of capitalism. It is not the result of speculating in short term price changes. There is no additional expected return from speculation above the average return. The gains from speculation are offset by the losses in any random situation, leaving the average, or the index, as the most likely return. This concept is known as a zero sum game. Investors earn returns from consistant exposure to the right risk factors, not from gambling on tomorrow’s news.

5. Market Efficiency Is Why Capitalism Works Better: The world’s stock exchanges facilitate a free market system that is the cornerstone of capitalism. These capital markets simultaneously price the cost of capital and the expected return from the risk of capitalism. Free markets perform this highly important task in the most effective and efficient manner because the knowledge of all investors exceeds the knowledge of any individual. Due to the millions of intelligent and highly competitive investors, it is unlikely that any individual investor will consistently profit at the expense of all other investors. From this we can conclude that free markets work and that current prices reflect the knowledge and expectations of all investors at all times. This concept is known as the Efficient Market Theory. If free markets were not more efficient than the controlled markets in communist countries like North Korea or Cuba, then the communists would be more prosperous than the capitalists.

6. Cost of Capital and Expected Return for Capitalists: The expected return for a capitalist, equity buyer, or investor is equal to the cost of capital of the equity seller. An intelligent capitalist will estimate the expected return based on the risk of the equity, which is tied to the risk of the company. The higher the risk of the company, the higher their cost of capital, and the higher the expected return for the capitalist. The lower the risk of the company, the lower their cost of capital, and the lower the expected return for the capitalist. Those investors who carefully match their risk capacity with their risk exposure have the best chance of obtaining the long-term historical returns of the global markets. A buy, hold, and rebalanced risk exposure strategy is the best method to capture those returns.

7. Small Value versus Large Growth Companies: Public companies that are unglamorous, small, and relatively cheap (small value) are riskier and have higher costs of capital than those that are glamorous, large and relatively expensive (large growth.) As a result, a dollar invested in a Fama/French Index of small value companies in 1929 grew to $30,376 by the end of 2003 (14.3%/year), and a dollar invested in a Fama/French Index of large growth companies grew to only $1,179 over the same period (9.6%/year.)

8. Diversify, Diversify, Diversify: Diversification is the investor’s best friend because it reduces the uncertainty of expected returns, otherwise known as risk, without changing the expected return. Concentrating investments only adds risk, and does not increase expected return. For example, any one stock in the S&P 500 has an expected return of about 10% per year, plus or minus about 50% two thirds of the years. However, the S&P 500 Index has the same 10% expected return, but it only has a risk of plus or minus 20% two thirds of the years. So 10% plus or minus 20% is far superior to 10% plus or minus 50%. Highly efficient portfolios of index funds have had returns of 14.3%/year with risks of 15.6% over the last 34 years, after fees (see Index Portfolio 100, which includes about 15,000 companies from 35 countries.) This is why buying the whole haystack (index) is better than looking for the needle (a stock) in the haystack. What is the risk and expected return of your portfolio, based on the same investment strategy over the last 34 years?

9. Selecting Index Funds: Dimensional Fund Advisors is the premier commercial provider of capital markets research, historical risk, return and correlation data, investment advisor education, and mutual fund products that reflect the leading academic research. Their complete product line of index mutual funds are based on the efficiency of capital markets. They have constructed unique rules of ownership for their funds that allow investors to better capture the right risk factors and engineer portfolios with greater precision and efficiency. At the heart of their fund eligibility rules is the Fama and French three-factor model, which has become the gold standard among academic researchers for risk-adjusted returns. The three-factor model on average explains more than ninety percent of the performance of diversified portfolios of stocks.

10. Peace of Mind: Don’t let your retirement years be tainted by the discomfort of poverty. Reliance on family members or government programs for your financial well-being will be a source of unhappiness, insecurity, and low self-esteem. The sooner you start saving and planning for your retirement, the better. A prudent and intelligently managed investment portfolio of index funds has the highest probability of providing security and peace of mind in the years when it will be needed the most.